Itaú BBA - The Feasible Fiscal Adjustment

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The Feasible Fiscal Adjustment

November 14, 2014

The Brazilian economy needs macroeconomic adjustments to regain sustainable growth.

The Brazilian economy needs macroeconomic adjustments to regain sustainable growth. One of the main adjustments is fiscal, through an increase in the primary surplus. But what’s the feasible fiscal adjustment under the current conditions?

On the one hand, the fiscal adjustment is essential to rebuilding confidence in the economy. On the other hand, the implementation of this adjustment is challenging in the short term.

In general terms, we believe in a macro scenario of minimal adjustments: sufficient to avoid economic deterioration, but not deep enough to generate a vigorous growth recovery. Our expectations for fiscal adjustment are in line with this scenario. We believe that the government will adjust the public account by up to 1.0% of GDP, reaching a primary surplus of 1.2% of GDP in 2015.

The primary surplus needed to stabilize the debt-to-GDP ratio is higher than the forecast for next year – we estimate a necessary primary surplus between 2.0% and 2.5% of GDP. Evidently, the fiscal adjustment will have to be multiannual, extending beyond next year. A successful start in 2015 may generate the confidence needed to maintain the adjustment in the following years.

The magnitude of next year’s adjustment is comparable to that of 2003 and 2011. The impact of the adjustment is already considered in our economic activity and inflation estimates for 2015.

But there are clear implementation risks, given the difficulty of the adjustment, particularly in a scenario of modest growth and high inflation.

The incentive to adjust is clear. In addition to avoiding a deterioration in risk perception, the fiscal consolidation trend over the next years is likely to have a positive impact on confidence and growth.

Fiscal Dynamics in Recent Years

Over the past three years, the primary surplus in the public sector fell from 3.1% of GDP in 2011 to 2.4% in 2012, 1.9% in 2013 and 0.6% in the 12 months ending in September 2014. Our estimate for recurring primary surplus, which excludes non-recurring revenue and expenses, dropped from 2.7% of GDP in 2011 to -0.5% in September 2014 (see chart).

The decline in primary surplus stems from the impact of the economic slowdown on tax collection as well as a more expansionary fiscal stance on both revenue (tax cuts) and expenditure. Tax collection growth has been relatively stable in real terms in 2014, while expenditures have grown 5.3% – significantly surpassing potential economic-growth estimates. The central government's recurring revenue to GDP has declined moderately since mid-2012, after rising steadily from 2000 to 2007, while its total expenditure to GDP remains on an uptrend (see chart).

The reduction in primary surplus, combined with the recent increase in the government’s debt financing costs, has been putting additional pressure on public debt. The public sector’s net debt as percentage of GDP has risen 2.4 pp this year, to 35.9%. General government gross debt has grown 5.0 pp, to 61.7% of GDP. The divergence in the increase between the two is partly explained by the exchange-rate depreciation (which mitigates the rise in net debt) and Treasury loans to BNDES (which only affect gross debt).

Given that interest expenses are likely to remain high going forward, the maintenance of the primary surplus at current levels is likely to consolidate the uptrend in public debt. Our debt-dynamics simulations show that, if the primary surplus remains stable at 0.0% of GDP from 2015 onwards (level still higher than the recurring primary surplus estimated for 2014), net debt will increase by more than 10 pp of GDP over the next four years (assuming a stable exchange rate). According to our calculations, the primary surplus required to stabilize public debt in the long run is between 2.0% and 2.5% of GDP (this estimate assumes potential GDP growth of 2.5% and real interest rate of 4.0% in the long term).

The debate on fiscal adjustment, which rebalances public accounts and ensures the sustainability of public debt, therefore seems relevant at the moment.

Is It Possible to Adjust?

We believe that a change in fiscal policy that raises the consolidated primary surplus to 1.2% of GDP in 2015 and 1.8% of GDP in 2016 is feasible. This adjustment would signal the government’s intention to maintain the equilibrium of public accounts. The adjustment would require efforts on both the expenditure and revenue sides, as well as contribution from both central and regional governments.

A significant adjustment of central government expenditures is difficult to implement. The first challenge is that, if we only take into account the minimum wage increase next year (close to 9.0% in nominal terms, according to the rule that still applies to 2015) and the expected increase in social security beneficiaries,  social security, LOAS and RMV costs will increase by around 0.2 pp of GDP in 2015 by our estimates. To compensate, the government could: i) maintain the administrative expenditures ("outras despesas de custeio", comprising mainly the expenditures through the ministries: Defense, Social Development, Education, Science & Technology, etc.) stable as a proportion of GDP, which would be a significant change from previous years when expenses in this line grew by 0.2 pp of GDP per year; ii) implement a cut of 0.3 pp of GDP on investment (other capital expenditures); additionally, the government can iii) implement the already-signaled changes in the rules of survivor pensions and unemployment insurance. We believe that these rule changes would save around 0.2% of GDP. In the end, the central government’s total expenditure would decrease about 0.3 pp of GDP next year (from 19.6% to 19.3% of GDP).

On the revenue side, the fiscal adjustment will require an increase in the tax burden, which could happen via tax-cut reversals and the creation / re-formation of new taxes:

Cide: Our scenario includes revenue of BRL 5.0 billion (0.1% of GDP) in 2015, through the reconstitution of the Cide fuel tax. We assume an increase in Cide to BRL 0.07/liter for both gasoline and diesel, to be announced by year-end 2014 or early 2015, and take effect in April 2015 (due to the 90-day grace period for increases in the contribution rate). Changes in Cide are carried out via decree, without the need for Congressional approval, provided that it does not exceed the upper limits set forth by law (BRL 0.86/liter for gasoline and BRL 0.39/liter for diesel).

IPI: We assume a 3% to 5% increase in the IPI (tax on manufactured items) for automobiles and a partial reconstitution of the IPI tax rates on certain appliances, furniture and construction materials by the end of 2014. Together, the new rates would generate an increase in revenue from 2014 to 2015 of approximately BRL 4.0 billion (0.1% of GDP). The IPI exemptions currently in force are expected to expire at the end of 2014.

Revenue via increases in gasoline and diesel prices: In addition to the increases in Cide, our scenario also assumes additional increases in gasoline and diesel prices in order to reduce the gap between prices observed in Brazil and abroad. This, in our view, generates an increase in revenue (primarily through dividends and income tax from the oil and gas industry) of around 0.1% of GDP for 2015.

Others: The adjustment would require the creation or reformation of new taxes or contributions, generating revenue of around 0.3% of GDP in 2015. This hypothesis involves higher implementation risks because it would require congressional approval.

Non-recurring revenue: As observed in recent years, tax authorities are likely to once again rely on non-recurring revenue from concessions, extraordinary dividends and Refis. Because the annual volumes of these revenues have been gradually declining (which is intuitive in the case of concessions and Refis), we estimate that non-recurring revenue will decrease about 0.1% of GDP  in 2015, compared with the volume expected for 2014.

For regional governments, we believe that an increase in primary surplus, to 0.3% of GDP from 0.1%, is possible. This is a feasible and relatively common adjustment for the first year in office – in the case of state governments.

Therefore, adding (1) the drop in central government spending, of 0.34% of GDP; (2) the revenue increase of 0.52% of GDP generated by tax increases (we estimate that unchanged tax revenue will grow at the same rate as GDP); (3) a decrease of 0.1% of GDP in non-recurring revenue; and (4) an increase of 0.2% of GDP in the primary surplus of regional governments, the consolidated public sector would reach a primary surplus of 1.2% of GDP in 2015. (Table 1)

In 2016, we believe that the persistence of a tighter fiscal stance will help raise the primary surplus to 1.8% of GDP. Part of the increase in the primary surplus would arise from the maintenance of the tax increases implemented in 2015. Our scenario also includes an additional increase of BRL 0.07/liter in Cide on gasoline (to BRL 0.14/liter) and a full reconstitution of the IPI tax on vehicles (to 7%), certain appliances, furniture and construction materials. Furthermore, we assume an additional cut of 0.2 pp of GDP in investment, administrative expenses ("outras de custeio") stable as percentage of GDP and an increase of 0.1 pp in the primary surplus of regional governments.



Considering the need for fiscal adjustment, but also the challenges in implementing it, we project a fiscal adjustment of 1% of GDP next year, taking the primary fiscal surplus to 1.2% of GDP. For 2016, we forecast an ongoing adjustment, taking the primary surplus to 1.8% of GDP.

This scenario involves a fiscal drag (determined by the variation of the structural primary surplus) of about 0.9% of GDP per year in 2015 and 2016 – a similar adjustment to the one carried out in 2002 and 2003, and already incorporated in our economic activity forecasts for the coming years.

There are clear implementation risks due to the difficulty of the adjustment, particularly in a scenario of modest growth and high inflation. But the incentive to adjust is also clear. In addition to avoiding the deterioration in risk perception, the fiscal consolidation trend over the next years is likely to have a positive effect on confidence and growth.


Luka Barbosa

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